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You may not be hooked on Candy Crush Saga—the popular smartphone and tablet game— but you probably know people who are. More than 90 million people play the game each day, and even though it is free to play, the game helped its producer, King Digital Entertainment, generate revenues of $1.88 billion in 2013.1

While the growth of video games overall has outpaced movies, music, and books (see chart below), the rapid rise of mobile and free-to-play online games has led some to wonder if traditional video game producers could thrive.

Not Fidelity OTC Fund manager Gavin Baker. He believes the outlook is bright for gaming overall and that traditional game developers have the potential to tap into their existing world-class entertainment franchises and large-scale analytics to succeed in this changing space. As for investors, he thinks the stocks’ valuations may not reflect that growth potential, which may spell opportunity.

Video games have seen consistent growth—outpacing most other entertainment industries

Game changer: mobile, free-to-play gaming

Baker points to two revolutions over the last decade have created growth opportunities for game developers now—the emergence of new ways to monetize free-to-play games, and the ubiquity of mobile devices.

Traditionally, game makers earned their living from the sale of the game. But free-to-play games have created new avenues for the game makers to produce profits—by selling consumers into game enhancements or virtual items that help them progress through the game for small amounts of money. That shift can open up huge new audiences.

“There are millions of people around the world who simply aren’t going to spend $500 on a console and $60 for a game,” says Baker. “A free game that allows small purchases creates a business model that may allow much greater access—you can go into a café in China and buy computer time, access the game for free, and then spend a few dollars to personalize it or get help advancing.”

The second huge change has to do with the maturation of the smartphone market. With more than 1 billion people globally now possessing smartphones, every 15 minutes on a train or in a waiting room has become an opportunity to play—and to make in-game purchases.

While investors have driven down valuations on many traditional game makers due in part to concerns that the rise of mobile and free-to-play games would be a threat, Baker thinks just the opposite may come to pass.

“People saw the performance of video game companies tailing off just as we had the emergence of mobile games and free-to-play online games, and that raised concerns by many investors about the outlook for these companies,” says Baker. “I think that performance was really being hampered by the console development cycle.”

The game industry has had a long-established cycle—new consoles would come out, game sales would grow and eventually peak, and then sales would decline until the next generation of consoles emerged. That cycle has become a little different in recent years, as console developers have decided to lengthen the cycle to try to maximize their investment. That has made the slowdown longer for game makers and has washed out the weaker players in the industry, according to Baker. But it doesn’t mean the future is bleak.

“To me, the long cycle caused the slowdown for game makers, but many investors confused the cyclical performance with a secular change, leading the stocks to trade below their traditional valuations,” says Baker. “The idea that a free-to-play iPad game would replace the immersive quality of playing Call of Duty on a 50 inch TV with surround sound is absurd—they are not substitute experiences.”

The more likely outcome, according to Baker, is that console games recover following last year’s introduction of new consoles. At the same time, he thinks established companies may tap into their strong libraries of games and work to monetize free-to-play versions of their games to broaden their reach.

Video game software sales cycle has changed. Time for a rebound?

US Console and Portable Gaming, Source: NPD

Mobile game developers

The fund Baker manages has also invested in gaming companies focused exclusively on mobile games for phones and tablets. His approach there is to look for companies with a strong lineup of games. The OTC Fund has invested in Gameloft—a top-five publisher on both IoS and Android.

“Ultimately what I think could be really exciting is taking these huge, hundred-million-dollar franchises and broadening their appeal with free-to-play, item-based versions of the games on smartphones, tablets, and PCs in ways that are complementary to their existing console-based versions,” says Baker. “In the end, the big gaming companies could have a huge advantage, because figuring out how to monetize a game like this is an analytics problem; it’s a big data problem. These companies are all building out back-ends where they could do that in a very sophisticated, scientific way that will likely make it hard for smaller companies to compete.”

The bottom line

While the methods of distribution, business models, and monetization of games are changing, Baker remains constructive on the gaming industry, especially for companies with well-known games and dedicated players.

“I think you have three structural and secular ways to potentially win with these companies: the upturn in the console cycle, a broader audience thanks to smartphones and tablets, and new revenues from item-based free-to-play games,” he says. “So that’s kind of the reason I’m bullish at a high level.”

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Before investing, consider the funds’ investment objectives, risks, charges, and expenses. Contact Fidelity for a prospectus or, if available, a summary prospectus containing this information. Read it carefully.

Views expressed are as of the date indicated and may change based on market and other conditions. Unless otherwise noted, the opinions provided are those of the author and not necessarily those of Fidelity Investments. Fidelity does not assume any duty to update any of the information.

As of January 31, 2014, Fidelity OTC Portfolio held 2.8% of assets in Electronic Arts, Inc., 1.82% of assets in Activision Blizzard, Inc., 1.35% of assets in Ubisoft Entertainment SA, and 0.676% in Gameloft SE.

Stock markets are volatile and can decline significantly in response to adverse issuer, political, regulatory, market, or economic developments.

Past performance is no guarantee of future results.

Investing involves risk, including risk of loss.

Diversification/asset allocation does not ensure a profit or guarantee against loss.

Information presented is for informational purposes only and is not intended as investment advice or an offer of any particular security. This information must not be relied upon in making any investment decision. Fidelity cannot be held responsible for any type of loss incurred by applying any of the information presented. These views must not be relied upon as an indication of trading intent of any Fidelity fund.

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